Q2-2024
THIS REPORT IS PREPARED BY
Writer: Teresa Marziano, Real Estate Salesperson
Executive Summary
The US Economy is propelling forward albeit at a slower pace than in 2023. Employment growth has continued, prompting many to believe in the elusive possibility of a “soft landing”. Corporate profits have exceeded expectations, and the US is attracting a disproportionate share of global investment funds. House prices remain robust in most geographies boosting consumer wealth. The rate of inflation, while still above the Federal Reserve’s target, is slowly receding. Overall, a benign economic landscape that has coexisted with a tighter monetary policy, an inverted US Treasury yield curve, and historically high real interest rates. The US economy has not buckled and its momentum has barely faded. US Economic Exceptionalism appears to be the diagnosis.
This unique economic profile is rooted in the Pandemic years. Household debt service payment as a percent of disposable income stands at less than 10% after touching 8.3% during the pandemic. These are the lowest levels since the 1980’s as households improved their balance sheet during the Covid shutdowns, helped by government subsidies and generous programs such as student loan cancellations. A wealthier US consumer is undoubtedly a very important engine of US and global economic growth. As evidence of this, the World Bank improved their outlook of world economic growth for 2024 from 2.4% to 2.6% attributing 80% of the improvement to the resilient US economy.
In contrast to US consumers, the US government is facing deteriorating fiscal health. Federal Public Debt as a percent of GDP grew from 105% in Q3, 2019 to 133% during the Pandemic. It has now declined to 122%, still double the level that prevailed prior to the Financial Crisis of 2009. The imminent risk to this high indebtedness is the possible difficulty of attracting investors to refinance new bonds as debt rolls over. A couple of weak Treasury auctions in June (10 and 30Y Bonds) moved yields higher as investors demanded higher compensation for holding Treasury bonds. The financial markets are concerned about the fair value of Treasuries given the price volatility over the last year and investors dislike uncertainty. Commercial real estate valuations and refinancing trends hinge upon the stability and direction of interest rates, however, no clarity has emerged as of now. In this environment, real estate investors will demand higher compensation for risk.
Most commercial real estate segments of the market have participated in the US economic vitality through resilient occupancy. Rents have been helped by a strong consumer and broad inflation trends. However, occupancy driven cash flow gains over the last three years cannot compensate for the negative impact on value brought by increases in financing costs and capitalization rates. Office properties are an exception from the favorable operating cash flow trends. They have experienced cash flow declines on top of higher capitalization rates. In addition, they and facing well known and unique occupancy dynamics, that will redefine this segment of commercial real estate for years to come.
US banks hold roughly half of the US CRE debt with regional banks holding a disproportionate percentage of the total. Recently Moody’s has placed six smaller banks under review for credit downgrade due to their CRE loan concentration. The concern is clearly the 20%+ decline in CRE valuations and the refinancing needs of the asset class in the next several years. An estimated US $2.0 trillion of commercial real estate debt will come due between 2004 and 2006 which suggests that asset owners, financial partners, and investors will be very active in price discovery and in re-defining the right capital structure for assets that are refinanced Some level of commercial real estate distress appears inevitable, however, its impact
is impossible to forecast. For investors, the opportunity window may be narrower than expected. Massive amounts of funds have been set-up to be deployed in distressed commercial real estate; for the better assets, the competition may be stiff and cash buyers will always have the upper hand.
In the month of June, loan losses from CMBS dispositions (assets that cannot be restructured by CMBS servicers) reached 74.3%. This number is quite volatile from month to month, but disposition losses are slowly rising as financing commercial real estate is increasingly difficult. Overall, a small decline in interest rates is unlikely to provide a significant relief to owners facing imminent maturity. Additional capital is likely to be required to offset declines in asset values triggered by the current interest rate regime.
Westchester Offices - Remain in the Eye of the Storm CBRE and other sources report that approximately 8% of office buildings are attracting the bulk of the leasing activity. These buildings offer a combination of amenities and location that are far superior to the competition. These are, almost exclusively, Class A buildings. Overall asking rent growth, and effective rent growth is consequently, much stronger in this segment of the market.
Westchester office properties had a modestly favorable supply-demand balance during the quarter driven by direct leases. Sublet tenants returned space to Landlords, detracting from supply-demand dynamics. Leasing rates remained stable, driven by activity in the Class-A space, a trend that has persisted for several quarters. Workplace protocols have not yet stabilized, true office occupancy is still low by historical standards, and employers continue to identify opportunities to shrink their corporate office footprints. This trend has not yet reversed and office properties in Westchester and most other geographies remain difficult to lease and to finance.
Westchester Retail – Post Covid Retail Evolution Continues
Retail space demand in Westchester is brisk but selective. The evolution of consumer preferences is still shaping the retail landscape. Westchester has enjoyed the interest of national brands at the expense of more local retailers. In general, weaker brands focused on the mass markets are vulnerable to any slowdown in consumer spending and luxury brands are consolidating to preserve their pricing power, propelling additional space demand changes.
During the quarter, supply of space exceeded demand despite good leasing activity. Struggling retailers gave back space but this space could not be fully absorbed. Lease pricing remained stable and general inflation trends continued to benefit landlord’s realized rental prices.
Westchester Residential Apartments – Demand Sill keeping up with New Deliveries
During the quarter, deliveries were approximately 1.4% of stock, a large jump from prior quarter. Demand was strong, helped by seasonality, and this new product was absorbed without impacting pricing or causing vacancies to increase.
Executive Summary
The multifamily sector in Westchester has had a phenomenal performance over the last several years as new buildings, constructed near transportation hubs, captured the attention of young tenants and retirees. This great performance continues unabated. Rental rates are now moving forward at a slower rate, below the prevailing inflation rate, after multiple quarters of mid-single digit (annualized) increases.
Westchester Industrial and Flex- A Modest Slowdown in Demand
Reflecting a modest slowdown in economic activity, industrial space demand has receded from a frantic pace. The vacancy rate increased modestly during the quarter and supply-demand was unfavorable. However, lease pricing continues to be strong despite supply-demand imbalance. It takes time to re-lease industrial space as tenant requirements tend to be very specific. Increased availability may be an opportunity for tenants that had been discouraged for lack of space choices in prior quarters. We do not expect pricing to weaken as fundamental demand for industrial/flex space continues to be robust.
Westchester Transactions remain subdued
The direction of interest rates remains unclear, although the risk of further increases appears limited. Currently, it is fiscal soundness what is worrying markets, and such concerns are an important hurdle to interest rate stability and commercial real estate valuation visibility. In the near-term, owner occupiers and distressed assets will drive transaction volume. During the second quarter of 2024, transaction volume remained depressed but we expect volumes to pick up late third quarter and in the fourth quarter of this year, as CRE debt maturities increase.
About this Commercial Real Estate Report
This report was researched and written by Teresa Marziano. Please contact Teresa (914- 441-2254) or (TMarziano@ HoulihanLawrence.com) for questions, comments or feedback about the contents of this report.
HOULIHAN LAWRENCE COMMERCIAL TEAM
Commercial real estate has entered a challenging period as low interest rate maturities start to come due. Interesting commercial real estate investment opportunities are likely to become available. Liquidity is only available for strong sponsors and poorly capitalized owners will seek to sell. However, there are numerous market and economic risks that will add to the complexities of acquiring commercial real estate. Understanding the market forces that are shaping the fundamentals for each property requires a deep knowledge of the property, local and regional insights, and close contacts with the right financial partners. Our Team is highly skilled in all these areas. Reach out to HOULIHAN LAWRENCE COMMERCIAL for a complementary assessment of your real estate, an evaluation of a purchase target, and to receive an in-depth perspective on the ever-changing Westchester commercial real estate market.
Unemployment Rate in Westchester Stable Trends Consistent with a Robust Local Economy
Westchester’s unemployment rate remains low but has increased modestly in the last twelve months Nationwide job openings are not as plentiful as last year. Participation rate is increasing as wages and salaries become attractive enough to entice individuals not currently in the labor force pushing unemployment rate modestly higher
Sources: COSTAR, Trepp, US. Bureau of Labor Statistics, Unemployment Westchester County (Not Seasonally Adjusted) , NY. Real Estate Employees Data is Seasonally Adjusted. All data retrieved from FRED, Federal Reserve Bank of St. Louis; June 2024
Westchester County Unemployment Statistics- Not Seasonally Adjusted
Multifamily Assets Continue to Show Strong Fundamentals
WESTCHESTER, SOUTH OF I- ���
Multifamily rent growth has re-accelerated and new deliveries have been easily absorbed. Under-construction inventory is declining as the higher interest environment, lack of suitable land and steep construction costs discourage some developers from starting new investments in the sector.
Sources: COSTAR, Trepp, US Bureau of Labor Statistics, Data Reflects Fundamentals for Westchester County Area South of I-287. Price Index for Westchester retrieved from FRED, Federal Reserve Bank of St. Louis; June 2024
Westchester Office and Retail — Office Departures
Continue but Prices Hold, Retail Fundamentals Stabilize
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Office rental pricing has been stable despite sluggish demand as leasing transactions are concentrated in more costly, Class A offices. Also, higher costs for new Tenant Improvements (TI’s) encourage landlords to be disciplined in price
Retail shop fundamentals have been relatively stable. New concepts, are replacing older chains. Vacancies decline modestly while pricing holds.
Sources: COSTAR, Trepp, US Bureau of Labor Statistics, Data Reflects Fundamentals for Westchester County Area South of I-287. Price Index for Westchester retrieved from FRED, Federal Reserve Bank of St. Louis; June 2024
Industrial Properties – Slightly Cooler Fundamentals
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Industrial space data suggests that Industrial/Flex Demand has modestly cooled. Pricing, however, is stable at a multi-year high and there is scarce new supply. Prospects for the future continue to be favorable.
Sources: COSTAR, Trepp, US Bureau of Labor Statistics, Data Reflects Fundamentals for Westchester County Area South of I-287. Price Index for Westchester retrieved from FRED, Federal Reserve Bank of St. Louis; June 2024
Investment Activity Begins to Rebound — Price Discovery Starts
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Investment sales rebound but volume remains at weak levels underscoring valuation and financing concerns. Price discovery under a new paradigm of higher interest rates has started.
NOTEWORTHY BUT MODEST INCREASE IN TRANSACTIONS
Sources: COSTAR, Trepp, US Bureau of Labor Statistics, Data Reflects Fundamentals for Westchester County Area South of I-287. Price Index for Westchester retrieved from FRED, Federal Reserve Bank of St. Louis; June 2024